Dollar Weakness Resumes After Brief Reprieve

  • All eyes are on the two Georgia Senate runoff votes; if the Democrats win both seats, markets can expect another big slug of fiscal stimulus in 2021; the 10-year TIPS breakeven inflation rate has moved above 2% for the first time since December 2018; key US data for December start to roll out
  • UK Prime Minister Johnson announced a national lockdown; the economic implications are very negative; these developments point to larger budget deficits ahead
  • Germany reported much stronger than expected data; Israel was the latest country to announce harsh lockdown measures, despite being the frontrunner in vaccinations; NYSE decided against de-listing three of China’s larger state-owned telecom companies as it had previously signaled it would

Measures of implied volatility are picking up in in the equity space, but not so much in FX and bonds. The VIX and the EuroStoxx equivalent (V2X) are nearly back to their 1-year average, after their post-election dip. It’s worth remembering that the VIX tends to increase far more in downtrends than during risk-on periods, so it is not a pure measure of volatility. Despite widespread concerns about a reflationary backup in Treasury yields, we have yet to see this reflected in the MOVE index. FX implied vol in the G7 FX space remains around the 7% level, where it has been since the US elections.

After a brief reprieve yesterday, the dollar has resumed weakening. DXY made a new cycle low yesterday near 89.423 before recovering slightly on some modest risk off impulses related to negative virus news. Those impulses have faded today and so we continue to target the February 2018 low near 88.25.  Sterling made a new high near $1.3705 yesterday before UK lockdown news pulled the rug out. While sterling should participate in the weak dollar trend, it is likely to underperform within the majors (see below). The euro is on track to break above its recent high near $1.2310 and should eventually test the February 2018 high near $1.2555.  The yen is struggling to stay above 103 and we believe it is on track to test the March low near 101.20.

 

AMERICAS

All eyes are on the two Georgia Senate runoff votes today. The polls appear to be swinging modestly in favor of the Democrats and in turn, this has swung the betting markets in the same direction. That said, does anyone truly trust the polls anymore? With another record number of early votes and the likely legal challenges ahead, we may not know the Georgia results for days, if not weeks. The messaging from President Trump has been a mixed bag for the two Republican candidates, to put it mildly.

If the Democrats win both seats, markets can expect another big slug of fiscal stimulus in 2021. With a 50-50 tie, Vice President-elect Harris would cast the tie-breaking vote. Current Senate Majority Leader McConnell has made it clear that he will not pass more stimulus on its own, choosing instead to tie it together with measures on preventing election fraud and rolling back social media liability protections.  The House is unlikely to pass such a bill and so a stalemate is in effect. For now.

 

It’s worth noting that the 10-year TIPS breakeven inflation rate has moved above 2% for the first time since December 2018. Much of this is likely due to rising odds of a Blue Wave, but we remain unconcerned about inflation. Simply put, we see little in the way of inflation risks when there are no wage pressures. And we see little in the way of wage pressures when tens of millions are still out of work. Still, this is a theme that markets will wrestle with all year and the story is by no means finished.

Key US data for December start to roll out today. ISM manufacturing PMI will be reported and is expected at 56.7 vs. 57.5 in November. ISM services PMI will be reported Thursday and is expected at 54.5 vs. 55.9 in November. The employment components in both sectors will be closely watched ahead of Friday’s jobs report. December auto sales (15.8 mln annualized rate expected) will also be reported today. If so, this would be the first acceleration since September.

The Fed’s Evans and Williams speak. Yesterday, Evans said he favors aiming for 2.5% inflation. He became a voter in 2021, along with Barkin, Bostic, and Daly. At this point, all Fed policymakers are wholly in the dove camp but we think Evans is the first to specify any target or threshold for inflation. That said, the Fed is not going to tighten policy in 2021 (or 2022 or perhaps even 2023) no matter what happens on the inflation front.

Colombia reports December CPI.  Headline inflation is expected at 1.43% y/y vs. 1.49% in November.   If so, it would be another record low reading and would move further below the 2-4% target range.  Yet central bank Governor Echavarria has signaled there will be no rate cuts during the remainder of his term.  Next policy meeting is January 29.  His terms ends in early January, it will be up to his successor to determine if further easing is warranted then.

 

EUROPE/MIDDLE EAST/AFRICA

As widely expected, UK Prime Minister Johnson announced a national lockdown. It became effective Monday evening and will likely remain in effect until mid-February. UK is entering its third lockdown as progress on the vaccine has not been fast enough to mitigate rising hospitalization rates. Primary and secondary schools and colleges will close, with the exception of vulnerable children and the children of key workers. All non-essential retail, hospitality, and personal care services will close. The key issue here is the widespread concern about the new variant of the virus, thought to be as much as 70% more contagious. The good news is that the new strand doesn’t seem to lead to a more severe outcomes for those infected, and vaccines should remain effective.

The economic implications are very negative. The economy is likely to contract in Q1 as a result and this will delay the overall recovery even more. No wonder Chancellor Sunak just announced a £4.6 bln emergency rescue package to UK business in the form of grants to help them cope with the renewed lockdowns. More will probably have to be done for workers. The extended job furlough scheme expires at the end of April. With the recovery delayed by this current lockdown, the labor market will still be in bad shape then and so another extension seems very likely.

All of these developments point to larger budget deficits ahead. That in turn suggests a greater likelihood of more QE from the Bank of England, as the increased gilt issuance will require additional mopping up. Next policy meeting is February 4. While this is likely too early to see any action, it’s possible that the bank starts to prepare markets for the next slug of QE that will probably come at the March 18 or May 6 meetings. While the end of the Brexit drama removed a major headwind for sterling, this latest lockdown puts another headwind back on. While we remain negative on the dollar, we believe sterling will lag the other major currencies in the coming weeks. That suggests EUR/GBP is likely to test the September high just below .93.

Germany reported much stronger than expected data. November retail sales rose 1.9% m/m vs. an expected -2.0% drop and builds on the 2.6% gain in October. December unemployment fell -37k vs. an expected 10k rise and also builds on the revised -40k (was -39k) drop in November. The economy avoided the first rise in unemployment since June and this kept the unemployment rate steady at 6.1%. Germany remains the engine of eurozone growth, but it’s worth noting that Spain and Italy are starting to perform better. With the US outlook remaining poor in Q1, we look for economic outperformance by the eurozone which in turn should help drive the euro higher.

Israel was the latest country to announce harsh lockdown measures, despite being the frontrunner in vaccinations. Like the UK, the Israeli government decided to shut down schools. This might come as a surprise given the speed at which the country is administering vaccines, which has now reached over 15% of the population. Yet the shekel has shrugged this off, with USD/ILS trading just above the recent multi-decade low near 3.1940. This is the strongest since 1996 and is on track to test the 1995 low near 2.9680. This despite ongoing intervention by the Bank of Israel to slow the move. The bank just announced it had bought about $20 bln on the FX market in 2020, and it shows no signs of slowing its purchases.

 

ASIA

The NYSE decided against de-listing three of China’s larger state-owned telecom companies as it had previously signaled it would. No reasons were given for this abrupt U-turn, which led to an over 7% rally in these companies’ shares. Indeed, China’s CSI300 equity index hit a 13-year high. The continued appreciation of the yuan has also helped underpin the rally, as has the undeniable improvement in growth differential vs other major and EM markets. Not only does China have the virus under control, but the dual-circulation policy promises greater emphasis on the domestic market as an engine of growth, creating lots of new opportunities. Of note, iron ore prices in China are bouncing back strongly after a slump in mid-December. Inventories have fallen over 4%.